Effects of Inflation & How to Protect Yourself From the Consequences

7 impacts of inflation

Inflation whittles away the value of your money, making each dollar worth less and less over time. Yet economists say it’s also a normal and even useful part of a healthy economy. By understanding how inflation can be both helpful and harmful, you can learn to plan for it, using it to your advantage and protecting yourself against its more negative effects.

What Is Inflation?

The Reserve Bank of New Zealand (RBNZ) defines inflation as “the term used to describe a rise of average prices through the economy. It means that money is losing its value. The underlying cause is usually that too much money is available to purchase too few goods and services, or that demand in the economy is outpacing supply.” Looking at it another way, inflation is the overall decline in the value of money, since the more prices go up, the less each dollar is worth.

Need a practical example? Think back just a few short years, how much did petrol cost per litre?

The main way governments measure inflation is through the Consumer Price Index, or CPI. To calculate CPI, the government puts together a theoretical “basket” of goods and services a typical consumer might buy — rent, food, transportation, and so on. The total cost of all these items is the CPI.

The government keeps track of inflation by measuring and reporting how the CPI changes from month to month and from year to year. When people talk about the inflation rate, they typically mean the change in the CPI over the past year.

Since the year 2000, New Zealand’s CPI has averaged around 2.15 percent each year. But data from Statistics NZ shows the CPI for the year ending December 2021 reached 5.9 percent, meaning that prices rose by nearly 6 percent in just one year!

The Effects of Inflation and How to Protect Yourself

At first glance, inflation seems like nothing but a rip-off — stealing the value of your dollars and giving you nothing in return. However, economists generally see a modest level of inflation — maybe one to three percent per year — as a sign of a healthy economy.

When the economy is growing, consumers have more money to spend, and their higher spending drives the prices of goods and services up. Since wages usually go up along with prices, their overall purchasing power stays basically the same.

That doesn’t mean inflation is harmless. It can take a serious toll depending on your personal situation. However, if you know what to expect from the inflation rate, you can factor it into your financial decisions and avoid its worst effects in both the short and long term. Maybe you can even make the most of it!

1. Cost of Living

The most obvious effect of inflation is that it raises the cost of living. The more prices of goods and services go up, the more you spend each year on your overall expenses — housing, food, fuel, health care, and so on.

However, in most cases, price increases don’t affect all goods equally. For example, there is widespread reporting indicating prices of used cars, utes, and trucks had risen by as much as 10 percent in the last year! Petrol and diesel costs also rose noticeably. However, the CPI didn’t increase by as much as those two single items.

There are several ways to cope with inflation’s impact on the cost of living:

• Firstly, do your best to keep your income growing at least as fast as your expenses. If you’re working, your salary may rise on its own, or you can negotiate it higher.
• Second, since some prices go up faster than others, keep a sharp eye on the cost of specific items in your budget. For instance, if petrol prices are rising especially fast, you can make up for it by biking to work, taking public transport, carpooling, and generally driving less. If that’s not enough, you can adjust your household budget, putting more money toward the pump and cutting back in other areas.

Finally, if you’re currently planning a major purchase, such as a new car, consider making it as soon as you can afford it. Why? If inflation is at five percent per year, a car that costs $30,000 this year will cost $31,500 next year, and it will only go up from there. The sooner you pull the trigger on the purchase, the less you’ll pay.

2. Salary

For employees, one good effect of inflation is that it tends to drive up wages. This happens because prices are most likely to rise when consumers are buying more. This increased demand gives companies an incentive to produce more, which means they need to hire more workers.

However, when the economy is strong, workers have lots of jobs to choose from, so employers have to offer higher wages to compete. These higher wages, in turn, drive prices higher still. Businesses raise their prices to make up for their higher labour costs, and consumers are willing to pay these higher prices because they have more money in their pockets.

This benefit doesn’t affect all workers equally, though. Workers in the most competitive industries, where hiring is tight, will gain the most. They’re in the strongest position to ask for a raise that’s higher than the rate of inflation, so they actually come out ahead.

The workers who suffer the most are often those in unskilled jobs. These workers often earn only the minimum wage. As inflation drives prices up, unskilled workers like these have to pay more for everything they buy.

Thus, if you’re in one of these low-wage occupations, one of the best forms of inflation protection is getting a better job. If possible, look for a job in a field that’s expected to grow in today’s economy. And if you already have a good job, keep an eye on the inflation rate as you negotiate for a raise or promotion, and aim for a rise in salary that will outpace the rise in prices. Up-skilling and increasing your productivity is the best way to achieve this!

3. Employment

The main reason inflation tends to drive wages up is that it lowers the unemployment rate. As noted above, inflation tends to go together with high consumer demand, and high demand drives companies to hire more workers so they can produce more.

In general, this is a good thing for the economy. People who are working and earning spend more than those who are unemployed, and their spending keeps the economy growing.

However, high inflation doesn’t always mean high growth. In the late 1970s and early 1980s, the largest economy in the world, the U.S.A., experienced “stagflation” — a mixture of inflation and economic stagnation, or low growth.

In most cases, though, inflation is higher in a growing economy than in a slowing one. That makes a period of higher inflation a good time to look for a new job. Employers are more likely to be hiring, and workers are more likely to have jobs already, so there’s less competition for the jobs that are available.

4. Government Benefits

Inflation can be a good thing for workers, but it’s an unquestionably bad thing for anyone who’s living on a fixed income — that is, an income that doesn’t changes, no matter what happens to the economy. Examples include many public sector employees who are experiencing a pay freeze.

Sadly, as many prices are rising fast, people living on these wages will suddenly find that their fortnightly or monthly payments no longer buy as much as they used to. It may be their higher living expenses will leave them without cash left over for even small luxuries. At worst, they could be unable to make ends meet at all without social welfare.

If you find yourself facing higher expenses than your income can meet, to begin with you can look for costs you can cut to free up money in your budget. If that’s not enough, try looking for new sources of income to make ends meet, such as a side-hustle.

5. Debt

If you’re currently in debt, inflation is probably your friend. When the dollar is losing value every year, the dollars you use to pay off your debt represent less actual purchasing power than they did when you first took out the loan.

For example, suppose we pretend its way back in 1973, and you’ve just bought your first house with a 30-year mortgage which you set on a fixed rate for as long as you could. Let’s say the house cost $40,000, and your mortgage interest rate was 5%. That gives you a mortgage payment of about $215 per month.

The following year, inflation shoots up to 12%, and it stays above 6% for the next eight years. Each year, prices are rising by 6% or more, and your income is rising to match.

But your mortgage payment stays at that same $215 a month, year after year for the fixed period. You’re paying a smaller and smaller percentage of your income each year for housing, while the bank that loaned you the money is getting less and less value for its investment.

Banks are smart though, and they know this, of course. When inflation is high, they usually raise their interest rates to make up for the declining value of the dollar. The RBNZ also tends to raise interest rates to discourage borrowing, bring down consumer spending, and get inflation under control. Thus, high inflation today can mean higher interest rates and more expensive loans tomorrow.

So, if you know you’re going to need a loan soon, the best time to take it out is when inflation is on the way up. That way, you’ll be able to pay it off with cheaper dollars in the future. Of course, you might need to meet higher interest costs though!

6. Savings

If inflation is good for borrowers, it’s bad for savers — especially those who are keeping their money in cash and term deposits.

For instance, suppose you have $1,000 stashed away in a safe for emergencies. If inflation is currently at 4%, then by next year, that $1,000 will have only $960 worth of purchasing power. Over the course of five years at the same rate of inflation, your buying power will shrink to around $811.

Since savings don’t really pay off when inflation is high, it makes no sense to save more than you need to. This is a second reason why it makes sense to make purchases sooner rather than later when inflation is on the rise.

For anything else you can spare, the best bet is to look for investments that offer a better real rate of return than a savings account. How much risk and how much return you seek depends on your goals, situation, and how long the funds will stay invested.

7. Investment

Because higher prices usually go along with higher wages and consumer demand, the economy tends to grow faster when prices are rising. This growth boosts stock (share) prices, offering a chance for a good return on good companies.

Property such as family homes, apartments, and REITs can all be good when inflation rises too. That’s because landlords can usually put rents up to match or exceed inflation, which in turn increases the value of the properties.

Warning: the comments above are for long-term investors only, over the short-term, inflation can cause investment and property prices to fluctuate!

The Bottom Line: Inflation and How to Protect Against It

Inflation isn’t all good or all bad. It drives up prices and reduces the purchasing power of your savings, but it also drives up wages and typically boosts economic growth. That’s good for investors and for the economy as a whole.

In an inflationary environment, there are winners and losers. Investors, borrowers, and wage earners — especially those who are in a good position to up-skill and negotiate for a higher salary — come out ahead. Savers, lenders, and anyone living on a fixed income tend to fall behind.

Hopefully the list above will ensure you can stay on the winning side of the inflation game. With inflation, as with most things related to personal finance, planning is the key to coming out ahead in the long run.

If you'd like to discuss anything above with a trained professional, then get in touch.